accounting the value of accounting: essential to any business and those who don’t do it well not...

Accounting

The Value of Accounting:

• Essential to any business and those who don’t do it well not only waste money but are open to theft.

• By some definitions a company is really just money turned into different things.

• Accounting is all about that.

Accounting

Three Categories:

• Financial accounting• Managerial accounting• Tax accounting

Accounting

Who is it for?:

• Owners and prospective owners

Accounting

Balance Sheet• The Balance Sheet is so named because it

balances two things (actually three, but you group two together).

• The three things are: assets, liabilities and shareholder equity.

• The formula for accounting is:

A = L + Eor assets balanced with liabilities and shareholder equity.

Accounting

Balance Sheet• Assets are things that you own.

• Liabilities are what you owe.

• Shareholder equity is also what you owe (to your owners).

• Liabilities are that which is owed to the people the company buys things from to do its business including the people who invest in the company. The company essentially buys money from them.

Accounting

Balance Sheet• Why do they have to balance?

• Because that’s how accounting works. It’s a system of balance. You bought this and it cost that, so that and this equal each other.

• You put in $10,000 for this company and so it owes you that $10,000. It’s not going to give it to you anytime soon since it needs that money to run, but it does owe it to you.

Accounting

Balance Sheet• Here’s a simple Balance Sheet:

ASSETS LIABILITIESCash $12,000 Bank Loan $40,000Inventory 95,000 Owner’s Equity 80,000Other assets 13,000Total $120,000 Total $120,000

Accounting

Income Statement• Stuff that’s changing, mobile generally.

Accounting

Income Statement

Sales $10,000Cost of goods sold -2,500Gross margin $ 7,500Other expenses -5,300Profit before taxes $ 2,200Tax expense -770Net income $ 1,430

Accounting

More on the Balance Sheet

• You have a tire company.

• You buy rubber from a rubber making company and your company makes it into tires which you sell to tire stores.

• Okay, so what are your assets?

• Your assets are first your cash, which is the money you have in the bank. The rest of your assets are made up of the tires you make, the manufacturing plant you make them in, the rubber you use to make the tires and whatever chemicals you use to process the rubber you make it into tires.

Accounting


• Also your assets are the land you have your company on, and the office building your company managers work in.

• Finally, your assets are things like the money you haven’t been paid yet by your customers. This is called "Accounts Receivable".

• Also included in your assets are any loans you may have made to a client that have not yet been paid back. Have you ever financed a car from a car company? Same thing. And finally your assets are your prepaid insurance. An insurance policy is an asset because it can generate money for you.

Accounting


• Just because assets are immobile it doesn’t mean they’re not changing, at least a little.

• Your buildings and machines are actually getting a bit shoddier every year. So they are depreciating in value.

• Now accounting is a bit odd about that. There are different ways that things depreciate, or different ways you, as the business owner can claim you want your things to depreciate, but ultimately things like buildings and machines depreciate in value because they get used up.

Accounting


• What are your liabilities? They are your Accounts Payable, which is the money you haven’t paid the rubber company for the rubber you bought. They are the bank notes payable, the money you still owe on that $10,000,000 loan you took out to buy that new plant you desperately needed.

• They are your Taxes Payable, the money you still need to pay the IRS because you didn’t have your forms prepared when tax time came. And they are your Accrued Wages Payable, the money you owe to your employees because their union just cut a deal with you to raise their salary retroactively so you owe them money for the last year which you have not paid them yet.

Accounting


• The part that you add to your liabilities, the "E" part, is of course called Equity, the part of your company you owe to your shareholders.

• Sometimes that Equity is given to shareholders as a stock dividend or it is re-invested in the organization, becoming known as Retained Earnings.

Accounting


• Assets and liabilities (plus Equity) will balance by definition since starting at square one a company cannot exist unless it buys everything that makes it up.

• But you may ask. If I bought a building for a $10,000,000 and PAID for it then I have the $10,000,000 asset and don’t owe anybody anything. Not quite.

Accounting


• That $10,000,000 building is owned by the company, or the company stakeholders since they own the company and company bought the building.

• The money that bought that ten million dollar building had to come from somewhere and so that’s the balancing act of the Balance Sheet. It accounts for everything from what is to how it became what is.

Accounting

Cash Flows

• The final accounting statement we like to talk about is called the statement of cash flows.

• Basically cash flows are money that comes into the organization and goes out over a period of time.

• Now for your tire company that would mean the money you pay for things you get and the money you get for things you have or sell.

• But it’s complicated because your cash flow is not just money you actually get and give, it's money that denotes the value of something now versus what it used to be worth.

Accounting

Cash Flows

• For example, if you have something depreciate, like a machine, that loss of value becomes a negative cash flow.

• On the other side, your inventory might grow in value because tires for whatever reason suddenly become very precious. That can be listed as a positive flow of cash into your company.

AccountingCash FlowsHere’s a very simple cash flow statement:

Cash flow from operations +10,000Sales (paid in cash) +30,000Materials -10,000Labor -10,000

Cash flow from financing +40,000Incoming loan +50,000Loan repayment -5,000Taxes -5,000

Cash flow from investments -10,000Purchased capital -10,000

Total +40,000

Accounting

Value of Cash Flows

• Let’s say a company was a bit unscrupulous, and wanted people to think it was a little better off than it really was.

• They would want to show this in their annual report because that’s what a lot of big time investors use to determine whether or not they’re going to invest in a company.

• They might sell off some of their big machines they use to make their product and list the revenue from these as sales thus showing they made a lot of money that year.

Accounting

Value of Cash Flows

• What this would also show was that they made those sales with fewer machines, thus possibly giving the impression they were more efficient. However if you looked at the cash flows, you'd see that there was a large positive cash flow in capital equipment.

• If you put two and two together and matched up the increased sales numbers, you'd see that they were selling the very machines that made the product that made them successful in the first place. In other words you would be investing in a company that would likely not do as well the next year because they wouldn't have the wherewithal to do so.

Accounting

Value of Cash Flows

• Why would a company do this?

• A CEO might do it because if he made big sales one year he'd get a big bonus.

• How would he get away with it? Maybe next year they'd get into a brand new business and no one would care about what had happened the last year.

Accounting

Managerial Accounting

• Managerial accounting systems give you potentially valuable information regarding the operations of your company.

Accounting


• Managerial accounting is internally based and meant for a relatively small group of users as opposed to financial accounting, which is meant basically for the entire world.

• Also, managerial accounting is variable in its scope and how it is done, in as much as each organization does things differently.

Accounting


• Managerial accounting is a tool or set of tools.

• For example, at a private school, you might want to know how many of your graduating seniors are going to colleges and how many of them are going to prestigious colleges.

• You would want to know this to advertise your school to prospective students. Or rather the parents of prospective students.

Accounting


• Figures that you use for your business are called "metrics". Metrics are data that is used for the specific purpose of seeing how well a company is performing.

• One good example of a metric is the one Southwest Airlines used to use.

• They would measure whether or not they were turning planes every 10 minutes. A plane had to leave every 10 minutes from one of their airport gates.

Accounting


• If they managed to keep up that metric, they knew their business was functioning correctly.

• Now understand this in the larger context. If a plane was leaving every 10 minutes it meant a lot of other things were working right as well, but Southwest didn’t need to know those other things were functioning.

Accounting


• They could tell just by the one metric. Southwest knew its strategy well enough to be able to hinge all of its data on the one metric. It freed them up to do other things.

Accounting

Value of Accounting

• Accounting, though often not the most exciting pursuit in the world, is crucially important.

• Accounting is what finally put Ken Lay and Jeffrey Skilling behind bars.

Accounting

Value of Accounting

• Despite all the really nasty things Enron did in their existence, the only really illegal thing they did was not show losses on their accounting books.

• Enron had developed a methodology for buying and selling power generating companies that made them immensely successful, so much so that they got arrogant and ventured into businesses which they weren't as good at.

• In the process of doing that, they created what they called subsidiary companies, companies that did not have to be listed in their annual reports by an agreement Enron made with its shareholders.

Accounting


• Basically, the shareholders agreed that as long as Enron kept it's stock price at a certain level, they didn't have to tell them about any subsidiary companies.

• When these companies did poorly, Enron would actually sell them to other subsidiaries they would also create, companies that the public still didn’t know were theirs.

Accounting

Value of Accounting

• With all this cover up there were no losses in their own annual report.

• The fact that they were in effect using their own money to buy their own company and hide its losses was never known.

• How they broke the law was, when their stock price did fall below a certain level, they didn’t report the news on these subsidiary companies.

Accounting

Value of Accounting

• Another thing Enron did is a little harder to understand, but not illegal per se. They would make a sale of, say, electric power to a particular region and list the money they got from that sale as a "capitalization". That is they listed the sale as an investment in the company, as if the money had come from a shareholder. This made them appear like a bigger and stronger company, which made them more attractive to other shareholders.

• Their accountant was complicit in all this. Their accountant was a company called Arthur Anderson. Anderson at the time was working for Enron in two ways.

Accounting

Value of Accounting

• One, it was their accountant, obviously, and two, it was their financial consultant.

• Arthur Anderson at the time swore up and down that the two sides of their work with Enron were not related. But of course they were.

• Anderson advised Enron how to finesse their accounting records, i.e., lie, to make their company appear to have greater value.

• The accounting side of Arthur Anderson turned a blind eye to it. Why you ask? Money. People were making a lot of money at the time, and a boom economy is the last place anyone wants to worry about the rules.

Accounting

Value of Accounting

• Actually, during the late 90s and early 2000s, there were many people who knew that the economy was poised for a major drop.

• They knew there was trouble ahead. Why didn't they speak up? Money.

• Aswath Damadoran of the Stern School at NYU calls this "The Theory of the Smartest Lemming". Basically it says that even if you can see you’re all heading off a cliff, when you're still making money, you figure you’re smart enough to get out of line just before you step off.

Accounting

Value of Accounting

• Fortunately most accountants are pretty honest. It’s hard work being an accountant and it’s not terribly exciting, but it can be satisfying to do something that is about truth.

• An honest and smart accountant is a valuable thing in today’s world. A smart and unscrupulous one is also valuable, but for a very different reason.

accounting the value of accounting: essential to any business and those who don’t do it well not...

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